Gameplay in Shenmue is diverse; while most of the game is spent walking around the atmospheric, life-like Japanese locations in a third-person 'chase cam' mode (talking to people, searching for things, solving puzzles, and so forth), it is interspersed with many 'mini-games', including forklift and motorcycle races, bar fights, chases down crowded alleys, full versions of Sega arcade games Space Harrier and Hang-On (both originally programmed by Shenmue creator and director, Yu Suzuki), dart games, and 'free fighting' sequences.

The fictional story of Shenmue begins on November 29, 1986 in the perspective of the protagonist Ryo Hazuki returning home to his family dojo to witness his father, Iwao Hazuki battling with a man dressed in Chinese attire, who demands he hand over an item known as the Dragon Mirror. Ryo intervenes in battle after his father is felled, but is injured by a blow from Lan Di. As his father refuses to reveal the location of the mirror, Lan Di lifts Ryo from the ground and threatens to kill him with a final blow, which prompts Iwao to reveal its location underneath the Cherry blossom tree.

After Lan Di's henchmen recover the mirror, he asks Iwao if he knows of a man called Sunming Zhao and then kills him after forcibly asking him to stand as a warrior to face his end. As Ryo lies injured on the floor of the dojo, Lan Di and his men leave the Hazuki household. After Ryo has partially recovered he feels that he must dutifully gain revenge for the murder of his father, and begins to instigate inquiries into the incident with the local people of his hometown, Sakuragaoka.